Perhaps no vehicle is helping to change the investment landscape more than the exchange-traded fund (ETF). ETFs are baskets of individual securities much like mutual funds with two key differences. First, they can be freely traded like stocks, while mutual fund transactions don't occur until the market closes. Secondly, expense ratios tend to be lower than those of mutual funds because many are passively managed vehicles tied to an underlying index or market sector.

Tutorial: ETF Investing

The primary benefit of ETFs is that they can be used to construct entire portfolios that can be traded easily. Also, they are usually well diversified because they are designed to replicate a specific index or sector. (To learn how ETFs are formed, see Introduction To Exchange-Traded Funds and An Inside Look At ETF Construction.)

Building an ETF Portfolio
If you are considering building a portfolio with ETFs, here are some simple guidelines:

  1. Determine the Right Allocation. Look at your objective for this portfolio, your return and risk expectations, your time horizon, your distribution needs, your tax and legal situations, your personal situation and how this portfolio fits in with your overall investment strategy to determine your asset allocation. (See Three Simple Steps to Building Long-Term Wealth for a more detailed explanation that incorporates a process recommended by the CFA Institute.)
  2. Implement your Strategy. Analyze the available funds and determine which ones will best meet your allocation targets. Phase in your purchases over a period of three to six months.
  3. Monitor and assess. Once each year, evaluate your portfolio's performance and your allocations in light of your circumstances. (To keep reading about allocation, see Asset Allocation Strategies and Choose Your Own Asset Allocation Adventure.)

We will break down each of these steps in the following sections.

Determine the Right Allocation
If you are knowledgeable in investments, you may be able to handle this yourself. If not, seek competent financial counsel. In determining the right allocation, consider the following:

  1. What is your objective (purpose) for the portfolio (e.g., retirement versus saving for a child's college tuition)?
  2. What are your risk/return objectives?
  3. What is your time horizon? The longer it is, the more risk you can take.
  4. What are your distribution needs for the portfolio? If you have income needs, you will have to add fixed-income ETFs and/or equity ETFs that pay higher dividends.
  5. Do you have any legal or tax issues that will have an impact on allocation?
  6. How does this portfolio fit in with your overall plans and unique situation? It is important to know how this portfolio ties in with your other investments and how much of your net worth will be invested in this portfolio.

Finally, consider some data on market returns. Research by Eugene Fama and Kenneth French resulted in the formation of the three-factor model in evaluating market returns. The three-factor model says the following:

  1. Market risk explains part of a stock's return. (This indicates that because equities have more market risk than bonds, equities should generally outperform bonds over time).
  2. Value stocks outperform growth stocks over time because they are inherently more risky.
  3. Small cap stocks outperform large cap stocks over time because they have more undiversifiable risk than their large cap counterparts.

Therefore, investors with a higher risk tolerance can and should allocate a significant portion of their portfolios to smaller cap, value-oriented equities.

Remember that more than 90% of a portfolio's return is determined by allocation rather than security selection and timing. Do not try to time the market. Research continually has shown that timing the market is not a winning strategy. (To read more about this subject, see our Financial Concepts tutorial.)

Once you have determined the right allocation for you, you are ready to implement your strategy.

Implement Your Strategy
The beauty of ETFs is that you can select an ETF for each sector or index in which you want exposure.

Once you know the basics, you are ready to select your ETFs. In making your selections, look for products that:

  1. Most closely meet your allocation needs for each sector or index
  2. Have the most favorable expense ratios

There are a number of product offerings. Following are links to the American Stock Exchange, which has more than 200 listed ETFs, as well as some of the largest ETF managers:

American Stock Exchange:
Managers:

  1. Claymore: Offers ETFs designed to provide the investment performance delivered by specialized investment indexes.
  2. First Trust: Offers ETFs benchmarked against a number of styles, sectors and special situations.
  3. iShares: Owned by Barclays. Offerings across every major domestic index and sector, including fixed income, as well as international ETFs.
  4. Powershares: Style, industry, commodity currency specialty access and broad-market ETFs, including the QQQQ (formerly the QQQ).
  5. Pro Shares: Uses derivatives, short (selling the asset) and long (buying the asset) index ETFs, including leveraged index ETFs.
  6. Rydex: ETFs that seek to capture the performance of equal weighted and segmented indexes and sectors.
  7. State Street Global Advisors: Standard and Poor's Depositary Receipts (SPDRs), specific sector and index ETFs (including fixed income) and the Streettracks ETFs, as well as tools to help build a portfolio.
  8. Van Eck Global: Market Vector brand of ETFs based on special market sectors and countries.
  9. Vanguard: Domestic and international index ETFs that cover a range of market segments, investment styles, sectors and industries including bond the bond market.
  10. Wisdom Tree: Index ETFs with a fundamental approach toward dividends and core earnings.

The next step is execution. ETFs trade during market hours, so any broker can execute your trades. More often than not, it is prudent to phase in new purchases. Data from The Stock Trader's Almanac show that, generally, the equity markets are strongest from November to April and weakest from May to October, which means you may choose to speed up your phase-in time during strong periods and slow it down during weaker months.

Monitor and Assess Your Portfolio

  • At least once a year, check the performance of your portfolio. For most investors, depending on their tax circumstances, the ideal time to do this is at the beginning or end of the calendar year. Compare each ETF's performance to that of its benchmark index. Any difference, called tracking error, should be low. If it is not, you may need to replace that fund with one that will invest truer to its stated style.
  • Balance your ETF weightings for any imbalances that may have occurred due to market fluctuations. Do not overtrade. A once-annual rebalancing is recommended for most portfolios.
  • Do not be deterred by market fluctuations. Stay true to your original allocations. Certain styles will stay out of favor for a while, while others will log abnormally high returns for extended periods.
  • Assess your portfolio in light of changes in your circumstances. Keep a long-term perspective. Your allocation will change over time as your circumstances change.

Conclusion
Remember, there are three steps to successfully building a portfolio with ETFs. One, determine the right allocation for you. Two, implement your strategy. And three, monitor and assess your portfolio in the context of your situation. If you follow these steps, you should be able to build a portfolio of ETFs that meets its intended objective.

To keep reading on ETFs, see Exchange Traded Notes - An Alternative To ETFs, How To Use ETFs In Your Portfolio and Advantages Of Exchange-Traded Funds.

Related Articles
  1. Fundamental Analysis

    3 Reasons To Not Sell After a Market Downturn

    Find out the reasons that it is not a good idea to sell after a market downturn. There are lessons to be learned from the last major market downturn.
  2. Mutual Funds & ETFs

    Which Fund Share Class is Best for Retirement?

    Mutual funds are a popular investment for retirement. Here's how to choose the best share class when investing in them.
  3. Fundamental Analysis

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
  4. Sectors

    2016's Most Promising Asset Classes

    Find out which asset classes are considered to be the most promising for generating portfolio returns and reducing volatility in 2016.
  5. Mutual Funds & ETFs

    Top 5 Wellington for Retirement Diversification in 2016

    Discover the top five Wellington Management funds for retirement diversification in 2016, with a summary and performance details of each fund.
  6. Mutual Funds & ETFs

    3 Morgan Stanley Funds Rated 5 Stars by Morningstar

    Discover the three best mutual funds administered and managed by Morgan Stanley that received five-star overall ratings from Morningstar.
  7. Mutual Funds & ETFs

    Top 3 Voya Funds for Retirement Diversification in 2016

    Learn about Voya Investment Management's mutual fund offerings and the three Voya funds to consider for retirement diversification in 2016.
  8. Investing Basics

    4 Things That Make a Stock a Safe Bet

    No investment is a sure bet, but you can reduce your chances of taking a loss by choosing fair-priced stocks with growth potential and low volatility.
  9. Retirement

    Smart Ways to Tap Your Retirement Portfolio

    A rundown of strategies, from what to liquidate first to how much to withdraw, along with their tax consquences.
  10. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  4. Do mutual funds require a demat account?

    A dematerialized account enables electronic transfer of funds. The account is used so an investor does not need to hold the ... Read Full Answer >>
  5. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  6. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center